When the market goes up 35% in two years, it's easy to see how one could think that it got overvalued. Especially so, when in a historic market slump, with tech stocks losing up to 80% or more of their value in a few months, tons of value stocks have remained flat or are within a few months price. That's why it's so surprising to find a stock that has remained relatively undervalued this year.
Stanley Black & Decker (SWK) offers the best combination of growth, value, shareholder capital return and strong business prospects in the industrial sector in my opinion. Not to mention the massive moat associated with strong brands and a leading market position. This should lead to substantial capital appreciation as its valuation catches up with its peers and the worries surrounding the MTD acquisition and its gas powered nature cool down.
Business Model
When we think of powerful business models very few of us think of the toolmaking business. That’s not to say that we would be correct in that statement. Owning some of the biggest brands in the world and being the leader in the tools & storage market means that the company has incredibly strong pricing power, free cash flow and dividend potential. Though not a sexy business, the tools segment has been growing since the dawn of time as industrial projects have gotten more and more complex, and as the population grew - and along with it grew the need for infrastructure. This all comes at a time when industrial activity and the need for skilled workers is only poised to increase - with a multiyear boom in industrials expected from the repair of America’s broken infrastructure, and a multi-year shortage in places like the housing market. All of these driving increased demand for both repair activity as infrastructure ages and as we build more of it. Essentially, SWK is an excellent bet on two major trends: the growth of the American population/economy and the increased development of society’s infrastructure; both virtually surefire bets - especially with the 1 Trillion dollar plan just passed
However, it is key to understand that part of my thesis is also the simple fact that the Stanley Black & Decker Portfolio in my opinion is superior and more innovative than the competition, and it's why they should realize further market share expansion.
Dividend & Growth Potential
Founded in 1843, Stanley Black & Decker has been operating for a long time, but even better, they’ve been paying out a dividend for 143 years, and growing it for over 50. This prized position as a dividend king is what makes this stock a rock solid income play. Yielding around 1.75%, the company does have a relatively low yield, however, the company has a dividend payout ratio of around only 25% - this means that it has more than ample room to grow it in the future. For context, consider that if the payout ratio was consistent with a dividend giant like Coca-Cola (KO), the company would have a yield of 5.75%. Also, if we give a different comparison to a company like Caterpillar (CAT) which is another industrial giant and a big dividend payer, SWK’s yield would be 3.15%. It's always been my approach to look for companies that have good adjusted yields. Though traditional dividend approaches look for companies that have high yields, I tend to weaken the weighting of this info, and look instead for yield adjusted payout, since that allows me to realize very long-term growth and allows management to distribute cash in different ways (like acquisitions and share repurchases).
The company’s approach of slowly growing the dividend over time has led to close to 8% increases in annual dividend distribution. To distribute additional excess capital they have instituted substantial share price repurchase programs. Following the sale of its security business for 3.2 billion, they were quick to announce the return of 4 billion to shareholders in share repurchases. Keep in mind, that represents 14% of the market cap of the company as a whole, all planned for purchase throughout 2022 - creating massive share price support for the stock, and limiting downside risk. The sale of the security business is also an excellent move by management with the idea of refocusing the company into its core business demographics. Keep in mind that Stanley’s security business was arguably its worst performing asset with net margins of around 7.5%, well below the tools segment for example at close to 19%. Additionally, the security segment was slow-growing, only at 5-8%, vs. the company’s well-above double digit growth. I believe that this was a very prudent move by investors to unload an underperforming asset and refocus the business. I think that this could result in serious shareholder capital return and an uptick in the margins of the business as a whole.
This divestiture is also a big part of allowing the company to purchase MTD & Excel. Both of these companies operate in the outdoor equipment sector and are an excellent adjacent industry expansion for SWK. The acquisition is very related and should create a much more efficient supply chain for the combined company and be very accretive to earnings/margins over both the short & long term - around $0.5/share immediately after the purchase. Finally, we need to keep in mind the primary risk associated with the stock - supply chain concerns. SWK has announced that supply chains are straining its ability to meet demand and meet its full earnings potential. Of course, this is a mixed bag - it means that they have more demand to benefit from down the road, but it also is problematic in the short term. A lot of these struggles stem from inflation since costs go up for running the business, and if you can’t pass them onto consumers you will lose out. Luckily, with best-in-class brands Stanley Black & Decker should have no problem ensuring that price increases keep their margins healthy. Overall, the company benefits from good industry growth trends, premium brands and an excellent position in its market.
Valuation/Margins & Balance Sheet
As the old adage goes, even an excellent company, with a wide moat, good margins and good growth prospects can be a bad investment if you pay too much for it. Luckily, I don' think that's the case with SWK. The stock is currently trading for about 14.5 times forward earnings despite expecting close to 20% sales growth - this of course going under the assumption that they are able to counteract supply chain concerns and the MTD acquisition goes as planned. This low valuation is in large part attributable to their excellent gross margins of around 35% - illustrating their strong moat and differentiation. If we compare them to their peers:
Caterpillar: 17.5 f p/e, and 30% gross margins - expecting 13% sales growth next year - with a 2.07% yield & 45% payout ratio
Home Depot (HD): 21 f p/e and 33.8% gross margins - expecting 3% sales growth next year, with a 1.89% yield & 43% payout ratio
Honeywell (HON): 22 f p/e and 33% gross margins - expecting 6 % sales growth next year, with a 1.9% yield & 47.8% payout ratio
The primary tools I use for evaluating a company are the relative valuation model - under which I simply compare the company's primary metrics to the metrics of competitors or industry peers. This gives me an idea of how the stock is playing in regards to the market. The second step is a Discounted Free Cash flow model:
Taking a share price of $175, and considering a 10% CAGR for the next 5 years, levelling off to just 3% after that - well below the company's self-guided growth, we arrive at a price of $205. This is based on a required rate of return of 11%, which goes to 12.75% with the dividend (a dividend that is poised to go up over time - while excluding share repurchases). I also decided to take 2022 earnings estimates since they better reflect the company's position moving forward with the new MTD acquisition since it was accretive to earnings.
This analysis quickly leaves you with a market beating earnings undervaluation on a FCF basis, with potential for growth through shareholder return of capital, and a 17% margin of safety to boot.
Just for illustration purposes, let's take a company like Caterpillar and do a FCF analysis:
Taking its current share price of $214 and assuming the same growth rates as SWK - which isn't likely considering they are expecting sales growth of 12% next year compared to almost 20% for SWK.
This would yield a fair value of $212 and at the same required rate of return of 11% - which would rise to 13% with the dividend yield.
As we can see, this provides an actual overvaluation of shares and illustrates Stanley Black & Decker's undervaluation.
Overall, it is clear to see that Stanley Black & Decker is relatively undervalued on an earnings basis to its industrial peers, with superior margins, faster growth & though having a slightly smaller yield, when adjusted for the payout ratio (and the fact that they are using the excess capital for share repurchases) we see that on a cash flow basis the company has the opportunity to distribute much more of its cash back to shareholders for its current valuation. All in all, it is clear that the company is being undervalued in comparison to the industry average & its peers - with both its cash generation potential and its growth prospects being underappreciated. The last thing we need to analyze for the company is its debt carrying capability and the strength of its balance sheet. The company has approximately 3.1x more debt than cash, which while initially seeming high is actually quite normal for the industrials business which requires a lot of working capital. Take Caterpillar at 4x, Home Depot and 4.75x - the only outlier being some companies like Honeywell that have very good capitalization (1.66x), but are valued very highly as a result (see valuation comparison). The next way that I like to evaluate ability to pay for debt is the company’s debt to EBITDA ratio:
SWK has a debt/EBITDA ratio of 1.67, suggesting that in under two years they could theoretically pay off their debt if that was their sole focus.
Compare this to Caterpillar who has a 5.5x debt to EBITDA ratio.
Home Depot boasts a 1.69 debt to EBITDA
Honeywell has a debt to EBITDA ratio of 3.46x
Analyzing the group, we see that SWK has the best debt/EBITDA ratio. Overall, this suggests that they are in an excellent position to cover their debt, and should have no problem both growing their business and returning capital to shareholders. I also think that this provides more than enough room to finance further acquisitions in the highly fragmented tools sector if opportunities arise.
Risks
Now, it can all seem like sunshine and rainbows when you look at it like I illustrated above, but in reality it can be a lot more complex. There are two big risks for the company.
1. Supply chain constraints
They have millions of dollars of inventory on ships waiting at ports to be delivered to customers whose demand far outpaces supply. This results in lost revenues, increased costs associated with shipping as they try to expedite and potential brand damage if they aren't available enough to consumers looking for them. Additionally, the inflationary environment can hurt margins as labour & such costs go up if the situation is prolonged. This uncertainty is what caused them problems during earnings as investors priced additional concern associated with their supply chain.
2. MTD & Excel Buyout
We've talked at length about why the acquisitions are a good idea, but there is always the question of integration. Whenever companies merge, there are anticipated synergies that make the deal work - if the company doesn't realize these synergies or the transition is harder than expected, it could harm their forecasts and thus all the assumptions we just made. There have also been serious criticisms of the need for purchasing a company in the outdoor equipment market since it can be tough to differentiate and isn't as high growth as the primary tools vertical. Though this is a risk, I view it differently, to me, the question for us as investors should be did the company make the right call exchanging the security business for the MTD & excel business plus over a billion in cash. I think yes, since the MTD & Excel business are faster growth and are at least closer to the tools business than security.
Earnings
Stanley Black & Decker reported decent recent earnings. Despite beating earnings and revenues, they did cause some concerns through their forecast on supply chain costs. Essentially, the company highlighted good organic and inorganic growth, specifically further reasoning surrounding the company's acquisition of MTD & Excel. The company did highlight margin compression and gave slightly lower margin guidance for the coming quarter in relation to the aforementioned supply chain risks. The gist of the earnings call, was general business success, being hurt by external factors, external factors expected to clear up past this year.
Verdict
I strongly believe that you have here the opportunity to buy a value stock in an overvalued market, with strong pricing power that counters inflation, a long secular growth runway and a valuation that is lower than its competitors by every metric (sales growth, f p/e, debt/EBITDA, dividend with payout ratio…). This company is committed to shareholder value & is unloading underperforming assets to repurchase shares & purchase higher performance ones in closely related sectors. Overall, this is an excellent pick for my portfolio, and it should handily outperform the market in 2022 and beyond!
By: Mateo Gjinali
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